Persistent Systems- 1QFY12 results below par, much to do in the remaining part of FY12 to meet investor expectations:: JPMorgan

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Persistent Systems Ltd. Overweight
PERS.BO, PSYS IN
1QFY12 results below par, much to do in the
remaining part of FY12 to meet investor expectations


 An unexciting quarter with concerns over margin performance down the
line. Persistent Systems declared 1QFY12 results that were below expectations.
Despite management confidence that they will be able to retain margins, and
PAT in FY12 as in FY11, we remain cautious and downgrade our numbers. We
are relatively more concerned about FY12 margin performance given the
offshore-centricity of the business model which renders Persistent’s margins
more vulnerable to wage inflation. Also, we think Persistent is leaving too much
to do in 2HFY12 to match FY11’s performance on margins/PAT.
 Weaker-than-expected performance of IP-led revenues the main cause of
underperformance. Revenue (USD) growth for the quarter was just 6.3%
(organic revenue growth of 4.5%) largely due to the tepid performance of IP
revenues (only USD 3 million, down 36% Q/Q). The growing composition of
IP-led or IP-based revenues is critical to improved margins as gross margins
this revenue stream are substantially higher at 55-60% (versus overall GM of
35-40%). Persistent is confident that this stream's contribution will be
substantially back-loaded; we do not share this view, given macro-uncertainties
and the difficulties, in particular, in consistently monetizing IP.
 Business model undergoing an evolutionary change. Despite volatility in
quarterly performance (partly due to the project-based nature of its
assignments), Persistent’s business model increasingly rests on a strategy that
combines (a) sell with partners in joint go-to-market models, (b) the four
themes of cloud, analytics, collaboration and mobility, (c) small acquisitions
that fill product niches in various verticals, (d) IP-based revenues. and (e)
greater use of technology consultants to help mine client relationships. This
gives breadth to the business model, but we believe Persistent also needs to
work on depth.
 Remain OW on valuations. We cut FY12/13 EPS by 12%/13% to factor in our
concern on margins. We remain OW because we think Persistent should be able
to grow revenues at well above industry average (>16-18%). Margins concerns
and expected EPS decline in FY12 are already in the price. We believe the
valuation is attractive at 10.4x FY13E EPS. We expect Persistent to trade at 12x
one year forward EPS, from which we derive our new Mar-12 price target of
Rs.430 (earlier Rs.500).